How Weighing Relative Strength Can Pay Off
During a time of "crisis," such as the recent Brexit incident, the market can collectively sink several percentage points in just a matter of days. A popular adage advises being greedy when everyone else is fearful.
But when everything looks grim, how do we distinguish between which stocks will recover and which will continue to get hammered? One crucial characteristic we can analyze is called relative strength. When the market is getting severely sold off, the stock that is somehow resisting the selling pressure and maintaining its price levels is considered to have high relative strength.
Relative strength doesn't necessarily mean that the stock must be putting in green candles during the selloff. Rather the ones that sell off but still manage to remain above significant support levels are those considered to displaying strength.
This is important because if the market recovers, the recovery is enough to act as a catalyst that can shoot the strong stocks into even higher territory. Flipping through most charts you can easily identify exactly which two dates Brexit influenced the market to stumble. However, if you come across a chart and it's basically impossible to tell that a market selloff even occurred, you have yourself a stock with relative strength.
Consider Kellogg's, $K, behavior at the end of June. When reviewing its chart you might easily overlook two candles, the ones displayed on June 24th and June 27th. But that's exactly the point! On these days, the candles never broke below its 20 DMA and its 50 DMA.
Prior to this point, $K was experiencing a clearly defined all time high resistance level at $78. But just a few days later the market's recovery caused $K to eventually gain over 10% without ever looking back. With all of its moving averages pointed upwards, multiple attempts at a breakout at $78.00, and very strong relative strength, this was the ideal trade after the panic. In some ways, Brexit was just the catalyst that $K needed to explode even higher by more than 10% into even higher territory.
Another example that fits many of the same criteria would be Burlington, $BURL. Although this stock experienced a gap down the morning of Brexit's announcement, it never broke below its 50 DMA and even went on to recover the remainder of that day. In just a few days time, it continued to break above its $64.50 level and continue to make new highs.
So next time the market sells off, watch for stocks displaying relative strength. If the stock remains in all-time high territory and displays a clearly defined setup, you might want to take a shot and enter. If the market recovers then these will be the stocks that will make the largest gains.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.